There is more than one spread strategy, making vertical spreads an umbrella. Vertical spreads are a popular options trading strategy because of the protection offered. This strategy will give you a higher probability of success and fixed risk while trading options! The most popular vertical spreads are credit spreads and debit spreads. They are a selling strategy, while debit spreads are a buying strategy. Credit spreads don’t need to be as directionally biased as debit spreads.
What Are Vertical Spreads?
Vertical spreads are the umbrella of trading spreads. The reason for this is that they house two different spread strategies. Vertical spreads are debit and credit spreads. They consist of buying and selling a strike price within the same expiration. They are meant to limit risk when trading naked options.
Options have moving parts to them. Options strategies were developed as protection. The great thing about options is their ability to make money in any market.
Options can be confusing and overwhelming, especially for new traders. Each strategy has a few different names.
For example, you can see bull put spread, bear call spread, debit spread, and credit spread. You’d see that and think they’re different strategies. However, they’re different names for the same strategy—vertical spreads.
Although they have different goals and outcomes, that’s important to remember. Investopedia defines vertical spreads as purchasing the same type of put or call option on the same underlying asset with the same expiration date but with different strike prices.
Options Basics
Before getting into vertical spreads, we need to understand the options. Options give us the right but not the obligation to buy (call) or sell (put) a stock at a predetermined price within a set time.
One contract controls 100 shares. As a result, trading options is cheaper. You can grow a small account trading the higher-priced stocks because you only pay a premium.
How often do new traders turn to penny stocks to grow an account? With options trading strategies like vertical spreads, you can profit from large-cap stocks while protecting yourself.
Hence, the appeal of options. They have strategies for when the market is bullish, bearish, or trading sideways.
Calls and puts are the most basic options strategy. They also make up every advanced strategy.
As a result, it’s important to learn how to trade calls and puts and what goes into their profit and loss potential. If that sounds overwhelming, don’t worry. We’ve got you.
Vertical Spreads Example
This is an example of a vertical debit spread on an options chain in ThinkorSwim. On the options chain, you’ll see strike prices that include in the money, out of the money, and at the money. Traders can also add intrinsic value, extrinsic value, implied volatility, and open interest.
Options Greeks are a vital part of a contract. They include delta, gamma, theta, and vega. Options charts are also popular to look at.
Credit Spreads
Two strategies make up vertical spreads. The credit spread is one.
The credit spread strategy is buying and selling the same option with the same expiration date but different strike prices.
In other words, you’re trading two calls or two puts. They both expire on the same day, but their strike prices differ. You receive a credit into your account at the start of the trade.
Credit spreads can also be known as bear call, or bull put spreads. Knowing that can make it more confusing.
When you believe the stock will go down, place a bear call spread. When you believe a stock will go up, it’s a bull put spread.
It’s an oxymoron since calls are typically bullish, and puts are bearish. Hence, there is a need to practice trade and study.
Debit Spreads
The other component of vertical spreads is the debit spread. Money is initially debited from your account, resulting in the debit spread name.
This is a directional strategy. As a result, you must choose the right direction. However, you’re more protected by buying and selling a contract.
Selling naked calls and puts doesn’t offer the same protection that vertical spreads do. Hence their popularity.
With this strategy, you want the number of options sold to be lower than those purchased. As a result, you must pay the money up front.
Options Chain
One of the reasons we’re focusing on vertical spreads is the options chain. By now, you’ve realized there is more than one name for vertical spreads.
However, if you find credit or debit spreads on an options chain, you will be looking for a long time. They’re under the umbrella of vertical spreads.
How you place the trade determines the spread you open. For example, when you sell a spread, it’s a credit spread. You’re receiving the premium of the trade.
When you buy a spread, it’s a debit spread. You’re paying money to place the trade. However, they’re both known as vertical spreads.
That’s why we want to pound this into you. Part of the difficulty of options is all the names for the same strategies. As a result, please don’t get caught up in the minutia of it.
Instead, you can focus on what way makes the most sense to you and go from there.
What Happens to a Vertical Spread at Expiration?
Vertical spreads consist of both credit spreads and debit spreads. It would be best to close out credit spreads at expiration to avoid potential assignments. Debit spreads are directional-based, so it’s best to take your profit before expiration or cut your losses. The longer you hold, the bigger your potential loss if the trade goes against you.
Practice Trading
Open a simulated trading account. That way, you can get familiar with the options chain, the moving parts of options, and how they all tie together.
Don’t jump into the deep end without using floaties first. That can be one way to learn how to swim. However, we’re trying to protect our money.
“Using paper money isn’t the same.” How many times have we heard that? Of course, it’s true. Real money causes a lot more anxiety.
That’s to be expected. You have tangible results as a result of real money. However, practicing ahead of time helps to work out the kinks.
Vertical spreads are an advanced trading strategy. As a result, you need to plan your trade. Vertical spreads are less risky because they’re less expensive.
However, jumping in with real money and no experience will shake your confidence, even if you start small. Sure, it’s only $30 here and there. But losing that adds up.
Practice doesn’t make perfect with trading. However, practice does allow you to test your strategy before putting skin in the game. That’s how you become successful.
Final Thoughts on Vertical Spreads
You’ll want to practice trading options in a simulated account since options have many moving parts. ThinkorSwim by TD Ameritrade is one of our favorites.
With a paper trading account, you can place hundreds of practice trades before using real money. As a result, you can work out the kinks and see what options trading entails.
Trading is emotional as well. As a result, practicing allows you to learn to control those emotions. However, we realize that it’s a whole different animal once you go live.
Losing money when practicing is much less risky than going full throttle out of the gate. It protects you as well as you learn how to sell a put.
Vertical spreads are the umbrella of trading spreads. You won’t look for credit or debit spreads on every options chain.
Frequently Asked Questions
Example of a Vertical Spread:
- XYZ stock is trading at $157.65
- Expiration date 2/16/24
- Buy a $155 strike
- Sell a $160 strike
- Results in $296 debit
Vertical spreads are a profitable trading strategy. Debit spreads are more profitable than credit spreads. However, they are riskier. Credit spreads are less risky than debit spreads; however, there is less profit potential.
Vertical spreads require the buying of one option strike and selling another option strike. Horizontal spreads had equal strikes with the same expiration date.
